Thesis

The impact of institutional framework, interest rate and demand on IPO underpricing : a theoretical model and empirical test

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Awarding institution
  • University of Strathclyde
Date of award
  • 1998
Thesis identifier
  • T9277
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Abstract
  • This dissertation acknowledges that the pricing scheme of initial public offering (IPO) is profoundly affected by the institutional framework within which IPOs are floated. Through the events of filing, red herring and road show, pricing, offering and first day trading, IPO underpricing develops via two stages. The first stage is the change experienced from mean initial filing price M (also known as the red herring price) to final offer price F. The second stage is the change from final offer price F to first trading day closing price T. The analysis applies the relative change from M to F to define an institutional variable of demand index and it employs the relative change from F to T to illustrate a core definition of underpricing at the second stage which takes place between the primary and secondary market. Based on the definitions outlined above a comprehensive model is developed; the model incorporates a basic model and an advanced model. The model demonstrates that the issuer selects an optimal offer price based upon investors’ optimal demand function. The model establishes propositions that underpricing is increasing functions of market demand, risk free interest rate, investors’ absolute risk aversion, aftermarket variance, total shares offered and decreasing functions of expected aftermarket price and offer price. The model also illustrates the roles of road show and underwriting in relation to underpricing. A cross-section empirical test is conducted on a sample of 531 EPOs issued in the United States between 1988 and 1993 to investigate the relationship between IPO underpricing and relevant institutional and other factors derived in the model. The analysis applies the procedure of market adjustment which is based on Dow Jones Industrial Average (closing) on red herring date, offer date and first trading day. The analysis of the data proves that underpricing is positively correlated with (1) demand index, (2) inverse of total proceeds and (3) the interaction between demand index and inverse of total proceeds. The univariate analysis reveals that higher interest rate is more likely to produce underpriced IPOs. The empirical test also concludes that when the final offer price is above mean initial filing price, the probability is 80 percent for investors to gain an underpriced issue.
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DOI
EThOS ID
  • uk.bl.ethos.881961

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